Buy or sell: the great US bonds debate

United States Treasury notes are the most liquid security trading in any market in the world. In recent years they’ve been working overtime to fund the US federal government’s trillion dollar-plus deficits. In the coming decade they’re going to have to work harder still.

Absent radical budget reform, federal deficits will total $US9.5 trillion over the coming decade, doubling US federal debt held by the public to $US20.8 trillion at the end of 2021, the Congressional Budget Office says. Most of this will have to be funded by the federal government issuing more Treasuries.

A market this large should be a model of efficiency at settling on a consensus price. In fact, while Treasury notes prices are historically high and yields commensurately low, views on where they will go in future differ wildly. Nobel prize winning economist and New York Times columnist
Paul Krugman
reckons the deeply indebted US government should take advantage of the ultra- low rates on offer and borrow more to build roads, ports, schools and hospitals. On May 8 he blogged: “It’s truly amazing that Washington debate is dominated by fear of the bond market. And it’s also truly amazing that nobody is suggesting that a government able to borrow long term at a real interest rate of 0.7 per cent really should be taking advantage of those rates to finance some much-needed infrastructure investment."

At the other end of the spectrum stands
Bill Gross
, managing director of Pimco, the world’s largest bond fund. Gross has been writing for months about the US government “skunking" Treasury note investors with rock-bottom real yields to make its debt spree affordable, and predicting that when the Federal Reserve winds up its QEII bond buying program at the end of June, prices will fall and yields spike if large foreign buyers such as China and Japan don’t step up. He has put his clients’ money where his mouth is by selling Treasuries and going short. He says in his May newsletter:

“If AAA quality is your requirement, then Canadian or Australian bonds may also fit your horizon. Join us, along with [economist] Carmen Reinhart, in shouting ‘constant bearing/ decreasing range!’ The Treasury market is on a collision course with financial repression and it is time to adjust your rudder to starboard to get home safely."

How could two such prominent experts come to such diametrically opposed views on the world’s most widely traded security? This is a debate whose outcome could determine the health of the world’s largest economy, and perhaps even such epochal questions as how soon will surging China and its rampant yuan eclipse flagging America and its weary dollar.

Tied up in the pricing of US Treasuries are such issues as the capacity of the US to service its swelling debt, the maintenance of the US dollar as a reserve currency, and inflation, growth and job creation. There’s also Treasuries’ role as the No. 1 haven in troubled times, and ballast to keep currencies low in export-led economies such as China and Japan. In other words, matters in which the world has a stake, and on which everyone can have a different opinion.

Take the US government’s credit. Bill Gross thinks it’s shot. S&P kind of agrees with him, assigning odds of one in three to the once unthinkable possibility that the world’s best credit for the last century could lose its AAA rating. Paul Krugman thinks it’s fine. The market kind of agrees with him. The real yield on 10-year Treasuries, measured by the Treasury Inflation Indexed Security, known as TIPS, has almost halved from 1.4 per cent in January to 0.82 per cent on Thursday (it was 0.7 when Krugman blogged on 8 May).

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Yet these are also issues on which first impressions can be deceptive, says Roger Early, senior fixed-interest portfolio manager at Delaware Investments, a Philadelphia-based unit of Macquarie Group with $US115 billion of fixed-interest assets.

Take the debt ceiling, the biggest game in Washington right now. The US Treasury Secretary,
Timothy Geithner
, and some Wall Street bankers have been preaching that famine, fire and pestilence will descend upon America if Congress doesn’t raise the $US14.3 trillion debt ceiling in plenty of time for the drop dead date of August 2, and that Republicans shouldn’t make this contingent on deep spending cuts.

Hitting the debt ceiling implies defaulting on Treasuries, so if there’s any danger of it happening, Treasury prices should be falling and yields spiking. But the opposite has happened. Treasuries sailed though Monday’s technical deadline.

This reflects a wide range of possible outcomes, Early says. If Congress raises the debt ceiling without any spending cuts, concern about creditworthiness will mount and Treasuries could come under pressure. But if Congress extracts some real budget austerity for raising the debt ceiling, “you could make an argument for lower rates" than today’s nominal yields of under 3.2 per cent.

Similarly, higher oil prices push up inflation, which could be bad for bonds, but they also crimp other spending and economic growth, which is good for bonds.

Or take QEII. A new or returning buyer in the market should be good for prices, but not long after the Fed returned to the Treasuries well in November, prices fell. Concern about the government printing money seemed to trump the demand effect. Now the Fed is poised to withdraw from the market (but not yet reduce its holdings), prices are as firm as they’ve been all year. Joy that inflationary money printing is coming to an end seems to be prevailing over the withdrawal of a large buyer.

So does this mean it’s time for the US government to take Krugman’s advice? Or for the rest of us to take Gross’s advice and sell Treasuries? Neither makes much sense, Early says.

“I understand the argument that if I can borrow for practically nothing and if I need to build roads and schools I should do that. The problem is that the perception around the world of the US taking on another layer of debt wouldn’t go down well. It would raise further concerns," he says.

“I think a more likely outcome of this is that US policy gets forced into a corner where we have to put in place austerity programs."

Early is encouraged by the vigour of the debt ceiling debate. “If they agree to raise the debt ceiling for some set of reasons without any kind of austerity being put in place, that would be the scary moment when Treasury rates would rise out of fear of the US raising more debt without having put in place any kinds of controls on spending."

Early believes expectations of Congress are low. “If they reached a real austerity that had some meat to it, you’d have to say that would at least be supportive for Treasury bonds," he says.

Perhaps the US government should take advantage of low rates by issuing 50-year bonds.